Getting Serious About TDF Sequence of Returns Risk

Ron Surz, president and CEO of Target Date Solutions, is known within the retirement planning industry as something of an outspoken and unabashed critic of a lot of the thinking behind proprietary and bundled target-date funds.

His website suggests that target-date funds (TDFs) are “a reasonably good idea” but with poor execution, “at least so far.” Most recently, Surz has been actively pushing the topic of sequence of returns risk in TDFs, and how this is a grave but largely ignored risk facing near retirees and those who have recently transitioned to the decumulation phase.

Before diving into the sequence risk topic, Surz recently commented to PLANADVISER that he is pleased overall to see the TDF topic become top-of-mind for more industry practitioners. And this is happening for a variety of reasons, he argued.

“I’m reading a lot about it these days in trade publications and in materials from providers, and I think nobody will be surprised to hear me say that I am vindicated by this. Sequence risk is such an important topic,” Surz observed. “You still commonly see the figure thrown around that target-date funds are approaching $1 trillion in assets, but in my opinion, it’s already getting closer to $2 trillion if you consider collective trusts and custom funds. The growth in TDF usage continues to be incredible, so it’s very important that we push the conversation forward with respect to understanding the risks associated with this growth.”

As Surz noted, it is no great surprise that a product that purports to do all the difficult lifting for an investor would be so popular. Individuals need the help offered by TDFs, but it also needs to be acknowledged how complicated TDFs really are when one digs under the surface even a little bit.

“It’s a little unfortunate that more digging doesn’t happen,” Surz agreed.

Asked for his opinion on the things that matter most with respect to assessing TDFs, Surz said first is fees, next is diversification, and the last thing is risk control.

“The rest of it, in my opinion, matters a little bit but not nearly as much as these three elements—so things like proprietary versus open architecture, whether it’s a mutual fund or a collective trust or a custom approach,” he explained.

Honing in on the risk control topic, a lot of the commentary Surz has put out lately makes the general argument that there is not enough attention paid to sequence risks in TDFs. The short of it is that people carry much more equity risk exposure than they ever realize, and there is thus a concern that if we enter another 2008/2009 environment, it’s going to mean a real rollercoaster for these people. With $2 trillion invested in target-date funds, that’s a huge amount of individuals’ wealth that is exposed, Surz argued.

“The concern certainly existed before, but now it’s even more pressing with the Baby Boomer retirement bubble—with the fact that TDFs and DC plans hold more assets now than ever before,” he observed. “Unfortunately, it’s not the easiest thing to do, to educate people about this different type of risk—the sequence of return risk. The way that I try to explain it to individuals is that, all of us in our working lives, we go through this heightened risk zone that lasts for about five or 10 years before and after retirement. It’s a relatively short time, but it’s a time when we really have to be more defensive with our wealth and our expectations.”

The fact that markets right now are frothy adds to this conviction, Surz said, but the point remains true whether the markets are volatile week by week or not.

“You can derail a successful long-term savings effort if you don’t make the right decisions in this window,” Surz continued. “I try to break it down in real terms for people. In 2008, many investors with near-vintage target-date funds saw this exact thing happen—their portfolios lost a third or more of their value right on the cusp of retirement. Today, with so many more accounts and assets fully invested in target-date funds, it doesn’t seem like we’ve learned the difficult lesson of being exposed to sequence of returns risk during the risk window.”

Surprising consensus

Stepping back from the conversation with Surz, readers may note the similarities between his take and the way J.P. Morgan’s Anne Lester speaks about TDFs—sitting as they do on more or less the total opposite ends of the provider spectrum. At a recent event held to unveil the updated 2018 Guide to Retirement publication, Lester talked in similar terms about the risk zone concept, calling this central to her team’s most recent development work on the J.P. Morgan SmartRetirement TDF series. Like Surz, she spoke about the importance of the risk zone, about being tactical in the decade that centers on the retirement date.

Also important to observe, neither Lester nor Surz are saying that retirees cannot invest and take some risk to fund their long-term goals. In fact, both mentioned recent academic research from Wade D. Pfau, professor of retirement income, The American College; and Michael E. Kitces, partner, director of research, Pinnacle Advisory Group. Their paper, “Reducing Retirement Risk with a Rising Equity Glidepath,” argues that, after workers navigate the risk zone, for many of them it makes sense to actually start ramping up equity risk, again in a controlled and rational way that balances the need for current and future consumption against the fact that the individual is aging and closing in on the end-date of their lifetime wealth trajectory.

“I think that paper was fantastic,” Surz said. “They do simulations, and they test a wide range of different approaches and glide paths that attempt to solve some of the key challenges such as longevity risk, sequence of returns risk, etc. The punchline of the paper is that the best performing glide paths are what you could refer to as a ‘U-shaped’ glide path. What does this mean? Basically, the best way to maximize consumption while also making sure one’s money last as you hit the risk zone is to start pretty conservative. Maybe just having 10% or 15% in equities as you’re entering retirement. Gradually as you age through retirement you can invest up to 35% or even 45% back into equities, as you get a better sense of what your true longevity may be.”

Surz and Lester both said this approach actually makes a lot of sense, as it acknowledges the very real fact that safe assets do not pay very well, while also acknowledging that retirees need at least some of their assets to be safe. Lester made the additional point that, for her team, there is definitely an understanding that the U-shaped glide path is objectively speaking the most logical approach for maximizing returns while addressing very real risks. Yet the J.P. Morgan TDF glide path created by her team does not significantly re-risk as retirees age and near the end-point of the portfolio’s assumptions. In her eyes, the behavioral challenges associated with explaining to retirees and beneficiaries why you are re-risking what amounts to an elderly person’s portfolio may be more trouble than it is worth.

Practical takeaways offered

Georgetown University’s Center for Retirement Initiative just released a new study that examines many of these issues. Among other conclusions, the paper found that the use of alternative asset classes such as private equity or real estate in target-date funds can increase retirement income and lower risk, “more so than funds based on only traditional equity and fixed income assets.”

Similar to Surz and Lester, the paper makes it clear that near-vintage TDF investors are seemingly underestimating the amount of risk they are carrying, pointing back to the example offer by the 2008/2009 recession. 

“Because plan participants fully absorb the gains and losses of their accounts, market events can drastically impact their ability to retire,” writes Angela Antonelli, executive director of Georgetown University’s Center for Retirement Initiatives, and lead author of the paper. “Consider the example of a worker ready to retire in early 2008 with $500,000 saved in her account, with 50% allocated to equities and 50% allocated to bonds. Between January 2008 and March 2009, global equities lost 41.1% of their value while U.S. bonds gained 4.3%.”

In that environment, Antonelli explains, this worker, “who was nearing retirement and thought she was invested appropriately, “would have lost over 18% of her net balance. The conclusion: “Her accumulated DC wealth would have dropped to around $410,000, potentially putting her retirement at risk.”

Particularly relevant to the discussion at hand is the section starting on page 19. Amid a pretty complicated set of projections and glide-path comparisons, the paper states that one seemingly straightforward way to mitigate downside risk is to shift more equities into fixed income, “though that approach would materially lower expected returns and adversely impact participants who intended to utilize the funds as a source for income throughout retirement.”

“Additionally, shifting from equities to core fixed income lessens equity risk but increases other risks such as interest rate and inflation risk,” Antonelli warns. “Instead, participants may be better off by further diversifying their portfolios. The diversified glide path aims to increase portfolio efficiency at a comparable risk level.”

The main takeaway of this section is that there are “several risk and return drivers in the marketplace, and most TDFs offered today are overly exposed to equity risk as a primary driver,” with interest rate and inflation as secondary factors.

“Diversifying asset exposures and broadening the investment opportunity set allows access to alternate return drivers (e.g., skill, illiquidity, credit) and provides benefits in scenarios where markets are stressed,” Antonelli concludes.

This section of Antonelli’s paper also considers the fact that, given Baby Boomers’ impending transition into retirement and the spending of accumulated savings, participants are also concerned with inflation risk, or the ability of a portfolio to protect against the erosion of real (inflation-adjusted) purchasing power.

“TDFs today often utilize Treasury inflation-protected securities [TIPS] to manage these risks,” she points out. “TIPS are bonds that are contractually set to adjust for realized inflation. TIPS also tend to come with the ‘cost’ of lower expected portfolio returns relative to other assets that may have a positive relationship with inflation (e.g., the inflation pass-through from real estate investments). As such, we review whether TDFs utilizing alternative assets can also help protect against inflation risk while maintaining higher expected returns.”

Running another set of projections, Antonelli concludes the inclusion of private equity, real estate and hedge funds modestly mitigate inflation risks for participants at the point of retirement. But that’s only part of the important story here. “Given the construction of the diversified glide path to target a similar risk level to the baseline at retirement, we see that the probabilities of large real-return shocks are comparable, but the probabilities of modest negative real returns are materially lower,” she explains.

Finally, Antonelli reviews the probability of sustained negative returns as retirement approaches. The research analyzes the probability of negative three-year annualized returns prior to retirement for different thresholds and compares how the alternate glide paths fares. In this case, the diversified glide path lowers the risk of losing 5% or more per year by 0.7% with the probability of losing 10% or more per year being comparable to the baseline.